Chapter 14

The Commercial Banking

Industry

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Chapter Coverage
Introduction to banking
The structure of (U.S.) commercial
banking
A trend toward consolidation
Branch banking
Bank holding companies
International banking
The convergence trend in banking
Bank failures
Changing technology
14-3
 Chapter Review
Portfolio characteristics of commercial
banks
Managing commercial bank
performance
Money creation and destruction by
banks and bank accounting

14-4
 Learning Objectives

To understand how important commercial

banks are to the functioning of a modern
economy and financial system.
To learn about bank financial statements
and how to read them.
To see how banks create and destroy
money and credit, and why this activity is
vital.

14-5
 Introduction

The dominant privately owned financial

institution in the economies of most major
countries is the commercial bank.

This institution offers the public both

deposit and credit services, as well as a
growing list of newer and more innovative
services, such as investment advice,
security underwriting, selling insurance,
and financial planning.
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 The Structure of
Commercial Banking
Banking structure
The number of commercial banks
The sizes of commercial banks
In most other nations the banking system
consist of a few large banking organizations
The U.S. system is numerically dominated
by thousands of small banks
However they tend to be smaller than banks
in other nations
But most assets are concentrated in a small
handful of banks
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 The Structure of
U.S. Commercial Banking
Number of Operating Insured Commercial Banks and
Branch Offices in the U.S., Year-end 2005

Source: Board of Governors of the Federal Reserve System Annual Report 2005
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 A Trend Toward Consolidation

One of the most important structural

changes affecting the banking industry
in recent years is the drive toward
consolidation of industry assets into
fewer larger banking organizations

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 A Trend Toward Consolidation

Pressures are operating to form larger

banking organizations
More efficient use of resources
The number of banks have fallen from about
14,000 to less than 7500
Average U.S. bank is larger than in the past
Largest U.S. banks gaining market shares
At the expense of small and medium banks
Largest saw market share go from 40% to 76%
Also average profitability higher
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 A Trend Toward Consolidation

Consolidation continues
Evidence the trend is slowing in the U.S.
It appears that mergers are being balanced out
by the creation of new banks
The industry might be forming a divided
organizational structure
Small number of global money-center banks
Community banks serving cities and
suburbs
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 A Trend Toward Consolidation
Research suggests that banks have
economies of scale
As a firm grows, costs grow slower than
output
Results in cost savings

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 Trend Toward Consolidation

Under economies of scale, larger banks are more

competitive
Benefits are limited
Level off at about $1 billion in assets
Larger banks tend to offer more services and bear
more costs

The increase in efficiency of production as the number of

goods being produced increases. Typically, a company that
achieves economies of scale lowers the average cost per unit
through increased production since fixed costs are shared
over an increased number of goods.
 Branch Banking

Consolidation of banks into larger

organizations
Most evident in the long-term shift toward
branch banking
Many of the nations largest banks have
followed their customers to distant markets
Branching
Mergers
Protect their sources of funds and their
earnings
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 International Banking

Bank expansion into international

markets has taken place through a wide
variety of organizational forms:
Representative offices
Branch offices
Acquisitions of existing overseas banks,
that then become subsidiaries of the
international bank
Joint ventures with foreign firms
14-15
 International Banking
Some of the Largest Banks Around the Globe

Source: Board of Governors of the Federal Reserve System and various central banks
14-16
 The Convergence
Trend in Banking
Convergence in banking
Banking organizations are looking more
and more like other financial-service
providers
Banks are offering many of the same
services as security firms, insurance
companies, etc.
Several banks in Canada, Great Britain, and
Western Europe long ago became
universal and merchant banks
14-17
 Bank Failures

Rapid expansion of bank services

Has not protected some banks and banking
systems from getting into serious trouble
Banks have failed
Due to excessive risk-taking
Intensified competition
Volatility of economic and financial
conditions
Crime
Etc.
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 Crime

Nicholas "Nick" Leeson is a former derivatives

broker whose fraudulent, unauthorized
speculative trading caused the collapse of Barings
Bank, the United Kingdom's oldest investment
bank, for which he was sent to prison. Since
leaving prison in 1999 he has become the CEO of
Irish football club Galway United and an after
dinner speaker.
 Changing Technology

Banking today is also passing through a

technological revolution
Computer networks and high-speed
information processing are
transforming the industry
Stressing convenience and speed in
handling such routine transactions
Making deposits
Extending loans
Paying for purchases
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 Changing Technology
Among the most important pieces of
technology
Automated teller machines (ATMs)
Point-of-sale (POS) terminals
Automated clearinghouses (ACHs)
Internet-banking
Recent changes have profound
implications
Bank costs
Employment
Profitability 14-21
 Changing Technology

One problem for online transactions

Increasing incidence of identity theft
At least 5% of internet users claim to
have given up online banking recently
due to security problems

http://finance.yahoo.com/news/story-man-outsourced-
china-could-135701981.html

14-22
 Portfolio Characteristics of
Commercial Banks
Primary reserves
Consist of cash and deposits held with other
banks
Reserves are the bankers first line of defense
Against withdrawals by depositors
Against customer demand for loans
Commercial banks hold securities acquired
in the open market
Long-term investment
A secondary reserve to help meet short-term
cash needs 14-23
 Portfolio Characteristics of
Commercial Banks

Loans are important to banks

Among the highest yielding assets a bank
can add to its portfolio
Provide the largest portion of traditional
banks operating revenue
Banks need funding to carry out lending
and investing operations
Draw on a wide variety of fund sources
About two-thirds comes from deposits
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 Portfolio Characteristics of
Commercial Banks
Monies set aside in case a loan defaults is
referred to as a loan loss allowance

It is the difference between gross and net loans

Annual contributions to the loan loss reserve is

referred to as the provision for loan losses

14-25
 Portfolio Characteristics of
Commercial Banks
Three types of deposits
Demand deposits (checking accounts)
Important for transactions
Safer than cash
Savings Deposits
Low interest rates
Low dollar amounts
Time deposits
Fixed maturity
Highest rate of return offered
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 Portfolio Characteristics of
Commercial Banks
Principal nondeposit sources of funds (Borrowings)
Purchases of reserves from other banks
Security repurchase agreements
Issuance of capital notes

Recently banks have turned to new nondeposit funds

sources
Floating-rate CDs and notes sold in international
markets
Sales of loans
Securitization of selected assets (auto, home
mortgage, credit cards etc.)
Standby credit guarantees 14-27
 Portfolio Characteristics of
Commercial Banks

Securitizations of Bank Loans to Raise Funds

14-28
 Portfolio Characteristics of
Commercial Banks

Letter of credit (L/C): An L/C is a document

from a bank guaranteeing that a seller will
receive payment in full as long as certain
delivery conditions have been met. In the
event that the buyer is unable to make
payment on the purchase, the bank will cover
the outstanding amount.

(http://www.investopedia.com/terms/l/letterofcredit.asp)
 Portfolio Characteristics of
Commercial Banks
Bank Standby Letters of Credit Issued on
Behalf of Their Customers

14-30
 Portfolio Characteristics of
Commercial Banks

Equity capital (or net worth) supplied by

a banks stockholders
Provides only a minor portion (only about 9
to 10 percent, on average) of total funds for
most banks today
Critical funding to the bank
Helps keep a bank open in the face of
operating losses
Minimal capital requirements
14-31
 Portfolio Characteristics
of Commercial Banks
Revenues
Interest and fees on loans
Interest and dividends on investment
security holdings
Expenses
Interest on deposits and other borrowed
funds is the principal expense item for
many commercial banks
The salaries and wages of their employees
are also a major expense
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 Portfolio Characteristics
of Commercial Banks
Banks expenses have been rising
Greater competition from bank and nonbank
financial institutions
Increases in the real cost of raising funds
Expense of upgrading computers and
automated equipment
Lowering interest margin
The interest margin
Net interest income less total interest paid
Measures how efficiency bank is performing
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 Portfolio Characteristics
of Commercial Banks

Recently interest expenses have been

dropping
Lower average market interest rates
Larger banks are evolving from
traditional structures into complex
banking companies

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 Portfolio Characteristics
of Commercial Banks
Also important is noninterest margin
Difference between total noninterest
income and noninterest expenses
Commercial banks are developing more
and more new services
Generate noninterest fees
Moreover, banks may minimize their
noninterest expenses,
Particularly employee costs
Substituting automated equipment for
labor
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Portfolio Characteristics of
Commercial Banks

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 Managing Commercial Bank
Performance Today
Bank assets, liabilities, revenues, and
expenses can be managed
Written loan policies
The positioning of the bank's investment
portfolio
Meeting the banks liquidity needs through
asset conversion or liability management
Paying special attention to the largest
depositors and to those customers with
large outstanding credit lines
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 Managing Commercial Bank
Performance Today
Recent research
Sources of liquid funds banks borrow daily
Proliferating rapidly
New challenges for bank management
Bankers rely less on traditional deposits
More dependent on innovative sources of
liquidity
Interest sensitive

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 Managing Commercial Bank
Performance Today
The performance of a bank
Evaluated relative to its own goals
Also evaluated relative to the
performance of its competitors

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 Bank Performance

 Bank Performance
Banks risk exposure like Ratio of Total Equity (net worth) to
Total assets
Banks risk exposure like Loan Loss Reserve: An expense
set aside as an allowance for bad loans (customer defaults, or
terms of a loan have to be renegotiated, etc.). Also know as a
"valuation allowance" or "valuation reserve".
Banks risk exposure like NPA - 'Non-Performing Asset -
NPA ' A classification used by financial institutions that refer to
loans that are in jeopardy of default. Once the borrower has failed
to make interest or principal payments for 90 days the loan is
considered to be a non-performing asset.
The banks operating efficiency (Operating Expenses/Operating
Income = 60 percent or below is good)
 Managing Commercial Bank
Performance Today
Note that performance measurement
should always take into account various
differences
Bank size
Location
Especially the product-line focus each bank
adopts as its principal service mission
Another important dimension of bank
performance is efficiency
14-42
 Money Creation by Banks and
Bank Accounting
Banks have the power to create money
Form of new checkable deposits
Credit card lines,
Debit cards
Other immediately spendable funds
The banking system can create a volume of
money
Equal to a multiple of any excess reserves
deposited
Simply by making loans and purchasing
securities 14-43
 Money Creation by Banks and
Bank Accounting

By making loans whenever excess

reserves appear;
The banking system eventually creates total
deposits and total loans
Several times larger than the original
volume of new funds received

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Money Creation by Banks and
Bank Accounting

14-45
Money Creation and Destruction
by Banks and Bank Accounting

14-46
 Implications of Money Creation

Creation of money by banks is one of

the most important sources of credit
funds in the global economy
Money created by banks is instantly
available for spending
Need for monitoring by government
Creation of money can fuel inflation

14-47
 Markets on the Net

ABN AMRO at www.abnamro.com

American Bankers Association Career
Website at www.aba.com and
aba.careersite.com
Bank of China Ltd. at www.bochk.com
Bank Systems and Technology at
banktech.com
Bankrate.com at bankrate.com
Barclays at barclays.co.uk
14-48
 Markets on the Net

Board of Governors of the Federal

Reserve System at
www.federalreserve.gov
CapitalOne at capitalone.com
China Construction Bank at
www.ccbhk.com
Citibank at www.citibank.com
Consumer Action at www.consumer-
action.org
14-49
 Markets on the Net

Federal Deposit Insurance Corporation

at www.fdic.gov
Federal Financial Institutions
Examination Council at www.ffiec.gov
Federal Reserve Bank of Chicago at
chicagofed.org
Financial Reports for Individual Banks
at www.fdic.gov/bank/individual
FYI and Bank Trends Publications at
www.fdic.gov/bank/analytical/fyi
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 Markets on the Net

IDC Financial Publishing at

www.idcfp.com
Industrial and Commercial Bank of
China at www.icbc.com.cn
ING Direct at home.ingdirect.com
JPMorganChase at
www.jpmorganchase.com
Keybank at www.key.com
Metlife Bank at metlifebank.com
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 Markets on the Net

Office of the Comptroller of the Currency

at www.occ.treas.gov
Sheshunoff at sheshunoff.com
Societe Generale at socgen.com
Unicredit Group at
www.unicreditgroup.eu
Veribank Riskwatch at
www.veribankratings.com
Wells Fargo Bank at www.wellsfargo.com
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